Canada will face many headwinds over the coming years. Debt, immigration, pension funding, and deficits are all areas that economists can see the cracks. Here we will investigate the Debt issue more closely.
Economists say that ‘Canada is 10 years behind the USA.’ Unfortunately, it seems that they are right again. The 2008 financial crisis was a result of overspending by the US consumer. 10 years later Canada isn’t in the same position, we’re in a worse position than the US was.
Canada’s consumer debt is skyrocketing and does not show any signs of slowing down. Debt to disposable income is unbelievably high coming in at 170% in Dec 2017 and with rising interest rates will likely be higher in Dec 2018.
To make matters worse housing prices have been rising over the same period. The new housing pricing index topped 103.20 in June 2018. The average home price has risen 45.01% over the last 5 years in Canada. Have the homes become 45% better? Of course not, but Canadians are still buying them.
How about the government, they aren’t getting involved in this debt picture right? Unfortunately, they are. Government debt to GDP levels are nearing 20-year highs. To make matters worse the Canadian government is aiming to balance the budget by 2019/2020. The odds of this balanced budget are extremely low however given the Liberal’s past 3 years.
Now add in the Central Bank of Canada. Their balance sheet is exponential. Whenever there is even a whiff of a recession the BOC swoops in to ‘save the day’ and purchase more equities. To make everyone happy the BOC lowers interest rates to the lowest rates seen to the Canadian consumer in history. Why wouldn’t you borrow? Money is cheap, everyone else is doing it, even the government is getting in on the spending action.
So where is the problem? It lies in inflation. Inflation is back in the Canadian market and it looks like it is here to stay. If inflation reaches a 3 handle in 2018 and possibly a 4 in 2019 as some economists have predicted the BOC will have to react. The BOC has indicated they will be raising rates and shrinking their balance sheet in the 2018 and 2018.
The picture we have painted is the perfect storm:
- Highly levered consumer
- High government spending still running deficits
- Rising inflation
- Rising interest rates
- BOC decreasing spending and beginning to sell off assets
There is one wild card in all of this. If Canada runs into a recession or a financial crisis, the BOC could do the same as it did in 2008: Print money and buy equities. If this were to happen it could cause a quick fix, but the Loonie would feel the pain shortly after.
What’s the play? If you’re looking to make some money on this, consider a short CAD Bank, long US Bank strategy. The dividends you pay on your short position would be mitigated by your long position. The Canadian banks are trading at a 1.8 price to book ratio in comparison to a 1.41 P/B for US banks.
The Canadian banks have had a great run over the past 10 years, but their customers are stretched financially. Loan demand will begin to slow, and defaults will rise as interest rates rise. The result is a stronger US bank in comparison.